Teva (TEVA) has been punished by a loss of exclusivity for its blockbuster multiple sclerosis drug Copaxone. While the financial impact has yet to be felt the rating agencies have rang the alarm. Moody’s recently downgraded Teva’s debt two notches from Baa3 to Ba2 – its second-highest junk rating:
Moody’s Investors Service (“Moody’s”) downgraded the senior unsecured ratings of Teva Pharmaceutical Industries, Ltd (“Teva”) and its subsidiaries to Ba2 from Baa3. Moody’s also assigned a Ba2 Corporate Family Rating, Ba2-PD Probability of Default Rating, and SGL-3 Speculative Grade Liquidity Rating. The rating outlook is stable. This action concludes the rating review initiated on December 14, 2017.
“The downgrade of Teva’s ratings to speculative grade reflects the challenge of managing its significant debt burden while facing a prolonged period of earnings erosion,” commented Morris Borenstein, Moody’s Assistant Vice President. “While Teva’s cost restructuring program will help to partially offset declines, execution risk is high. In addition, we believe earnings declines from Copaxone and its US generics business will be severe, and that meaningful deleveraging to under 4 times gross debt/EBITDA will take several years to achieve,” added Borenstein.
The ratings action follows a junk rating from Fitch in November. Going forward I believe investors should be wary of the stock for the following reasons.
Teva’s Financing Costs Are Likely To Rise
TEVA is up over 90% since hitting a 52-week low just after reporting disappointing Q3 results. While I tend to focus on its earnings fundamentals the stock appears to trade more on sentiment. Though its $34 billion debt load could exceed 4x EBITDA for an extended period, Teva’s interest coverage (EBITDA/interest) is robust. Its Q3 financial expenses were $259 million. This equates to a weighted average annual interest rate of about 2% – extremely low. Its EBITDA-to-interest coverage currently exceeds 6.0x.
Its abnormally low interest rates appear to be changing. Yields on its corporate bonds due 2024 now exceed 6.1%. The company has $7.5 billion in debt maturing through 2019. It will likely have to refinance the lion’s share of those maturities. New debt could be raised at rates of 6% or higher. I estimate that EBITDA from Copaxone likely represents 45% – 50% of Teva’s total EBITDA. Once Mylan’s generic Copaxone fully materializes in the first half of 2018 it could drive Teva’s total EBITDA much lower. Declining EBITDA and rising interest expense will likely hurt cash flow and cause its interest coverage to deteriorate.
How Long Can Management Forgo An Equity Raise?
I am on record that the potential hit to Copaxone and Teva’s EBITDA could cause its debt to exceed its enterprise value:
I also estimate that generic Copaxone could cut Teva’s EBITDA by about 34%, making it difficult to cover its $34 billion in net debt. Said another way, generic Copaxone could cause the company to become insolvent … At run rate EBITDA of $4.3 billion and a median multiple of 7.7x, Teva’s enterprise value of $32.9 billion would be less than its net debt of $34 billion. The previous chart illustrates this.
Instead of raising equity Teva CEO Kare Schultz has decided to cut costs and raise prices. Both events might not bear as much fruit as expected.
Certain Cost Cuts Have Been Delayed
In mid-December management announced plans to lay off up to 25% of its workforce in an attempt to cut $3 billion in operating costs. The cost cuts are expected to materialize over two years. However, the company recently delayed certain layoffs amid union strikes in Israel. Who is to say Teva will not make additional concessions on head count reductions and plant closings in the future?
While costs cuts are expected to be phased in the impact of generic Copaxone is expected to be felt in real time. Per Credit Suisse, Mylan’s (MYL) generic Copaxone has already taken a 10% share of Copaxone prescriptions. Market share loss in additional to price cuts Teva will have to implement to defend Copaxone will likely amplify Teva’s revenue loss from the drug. The real time hit to Teva’s EBITDA due to generic Copaxone could hurt its credit metrics in Q4 2017 and beyond, while cost take outs are still being phased in.
Price Hikes Could Backfire
Teva’s other big idea is to hike prices for some of its generic drug offerings:
But the debt-laden company said it also wants to stay focused on revenue — and hopes to wring more from its generic drugs business by raising prices.
There’s just one problem: Generic drug prices have been declining all year, posing a crisis for the industry and prompting the very cost-cutting that Teva just announced.
Teva may not have all that much agency to increase prices, in other words, since external factors have been pressuring generic prices down. The company effectively admits as much.
“Some of them we will succeed, some we will not. And those where we will not — we will discontinue,” Chief Executive Kåre Schultz said on a Thursday conference call, according to a FactSet transcript.
Several drug companies have announced prices hikes exceeding 9%. Teva has suffered from a decline in pricing power for generics, particularly in the U.S where prices have declined by double-digits. However, a price hikes could backfire. First of all, hikes might be driven less by market forces and more by that fact Teva’s debt is at junk levels and management does not want to raise equity. Secondly, major competitor Mylan has not intimated it will raise prices. Lastly, hospitals recently announced they will form their own not-for-profit generic drug maker. Additional competition could drive down generic prices further. Teva may have to change course on price hikes or potentially lose market share to competitors.
Conclusion
An expected rise in interest rates and fall in EBITDA makes TEVA a sell.
The Wire’s Chad Coleman Hosts Trump And The Global Economy February 6th
Trump And The Global Economy Town Hall took place October 24th in Fort Greene. It Featured Professor Lance Brofman, Coconut Rob (Coconut Rob Smoothies), Wuyi Jacobs (AfroBeats Radio) and Ralph Baker, author of Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead.
The event was well-received by the community. We parsed through President Trump’s proposed tax plan and [i] how it was pure economic folly and [ii] high net worth individuals could potentially game the system by shifting income around. Apparently, Kansas Coach Bill Self did this when the state of Kansas cut taxes in the past. We discussed the pros and cons of technology on workers and the economy. How will the economy and country prosper under Trump’s leadership? What’s behind the verbal sparring with black athletes, ESPN’s Jemele Hill and North Korea’s Kim Jong Un?
